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Law of Diminishing Marginal Utility

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The law of Diminishing Marginal Utility is an important law of consumption. It expresses the relationship between the quantity of goods which a person possess and the marginal utility of each unit of the good. A particular want is satiable, even though human wants in general are un-satiable. This theory has given rise to law of Diminishing Marginal Utility.

Marshall expresses the law as “The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.” As we go on consuming more and more of a commodity, our want for that particular commodity goes on diminishing and a point is reached when we do not require any more of it.

This is the point of safety or the point of complete satisfaction. Marginal utility of the commodity to the consumer depends upon the volume of the stock purchased by him. The larger the stock purchased, the smaller the utility derived from an additional unit of the commodity.

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The Marginal Utility of a good diminishes as the quantity of the goods increases. Let us take an example. One is extremely fond of rasagullas and his friend offers him as many rasagullas as he can consume at one setting. The person will be eager to have the first rasagulla and it will give him highest satisfaction. Having taken the first, he is less eager to have the second rasagulla and it will give him less satisfaction than the first.

The third one will give still less satisfaction than the second and so on. A point will reach when the person refuses to take any more rasagulla as his want for it has been fully satisfied. Then he will find negative satisfaction. This is the experience of every consumer when he consumes a commodity unit by unit during one setting. When the intensity of desire for a good is more it will have high utility for him. Gradually the utility for that good diminishes. But the total utility increases.

This law can be illustrated by the following table:

This table shows that as the consumer goes on consuming successive units of Rasagulla, the marginal utility of Rasagullas diminishes. For example, when the consumer consumes Rasagullas the first one gives him 100 marginal utility. But it diminishes to 80 when he takes the second unit. He gets marginal utility 50 from the third, 20 from the 4th and 0 or no utility, when he consumes the 5th Rasagulla. Again if he tries to consume the one he finds negative utility. Thus the marginal utility of rasagulla is diminishing by the consumption of each additional unit.

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This table shows that the marginal utility is becoming less and less when the consumption of rasagulla increases. From this table we can also know that, though the marginal utility diminishes, the total utility increases from 100 to 250 by additional consumption. At one point, it remains constant i.e. 250 in consumption of both 4th and 5th units of rasagullas. Then again it diminishes when 6th and additional units are consumed. For this reason, it is said that the total utility is increased at a diminishing rate.

This law of Diminishing Marginal Utility may also be geometrically illustrated in a diagram. In this diagram, units of rasagulla consumed are represented on the horizontal axis AB and Marginal utility on the vertical axis AC. When the first rasagulla is consumed the marginal utility is 100. It is represented by the height of the straight line drawn upward from the point 1 marked on AB. The utility of the second unit i.e. 80 is represented by the vertical straight line from point 2 marked on AB.

The third rasagulla gives the utility of 50 and the 4th unit 20 which are represented by the vertical straight lines from the point 3 and 4 on AB line. When the 5 th unit is consumed, the marginal utility becomes zero and then negative utility is gained when 6th unit of rasagulla is consumed.

A downward sloping DD’ line is drawn by joining the tops of all the straight lines which is known as Marginal Utility Curve. It indicates that the utility from successive units of continuously reaching ‘0’ at the 5th unit. DD’ line coming below AB line indicates that the utility of the sixth and subsequent rasagulla is negative. The consumer stops consumption at zero utility. If he continues, he will get disutility or dissatisfaction.

Assumption of the Law:

The law of Diminishing Marginal Utility is based on the following assumption:

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1. Suitable units:

It is assumed that units of commodity consumed are of suitable size. If the thirsty man takes water by spoonful, the utility he gets from the second spoon of water may be more than that from the first. The law therefore assumes that units of consumption are of suitable size. For example, a glass of water, a complete rasagulla etc.

2. Identical units:

The units of goods consumed are identical in size and quality. The second rasagulla may give you more satisfaction if the first is a small or rotten one. If the goods consumed are of uniform size and quality the marginal utility will diminish by each additional unit.

3. Quick succession:

It is further assumed that the units of the goods consumed should be within quick succession. There should not be more of time intervals between two units. If one takes one rasagulla in the morning and one at night this law cannot work. So this law assumes that the consumption of various units of the commodity is continuous.

4. Unchanged tastes:

This law assumes that the tastes of the consumer remain the same during the period of consumption. If the taste of the consumer will change suddenly, he may get increasing satisfaction from additional units. This law also assumes that other things like habits, temperament and income of the consumer will remain constant.

5. Independence of commodities:

The law assumes independence of commodities. It implies that the commodity consumed is entirely independent of other commodities in the market. So the utility derived from it is not influenced by the supply of other commodities in the market.

Exceptions or Limitations of the Law:

There are certain limitations of the law of Diminishing Marginal Utility:

1. Rare collection:

This law cannot be operated in case of collection of rare stamps, coins etc. A stamp collector gets increasing pleasure from the increase in the stock of his stamp. This is however an exception to the law.

2. Abnormal consumer:

A drunkard, madman and a miser are abnormal persons. They are all exception to this law. A miser is never satisfied with the acquisition of money. The more money he has, the more he runs after it and finds more utility from the additional unit. So this law is applicable to normal person.

3. Money:

This law is not applicable to money. Money has the purchasing power over all commodities. The more money we have, the more we desire to have increasing amount of money. So the Law of Diminishing Marginal Utility is said to be inoperative in case of money.

4. Habit:

The desire for a commodity sometimes arises from impulse, imitation or the possession of other individuals. In such cases, the law may not apply. Many commodities are purchased by us as a matter of habit. In these cases we do not consider marginal utilities.

Marginal Utility and Total Utility:

When a person consumes or possesses more than one unit of a good, the utility of each unit becomes different on the basis of Law of Diminishing Utility. The sum of utilities of all the units consumed is the total unit of the goods to the consumer. The utility of an additional unit is termed Marginal utility. When only one unit is consumed total utility is the same as the marginal utility. When two units are consumed total utility is the sum of the utility of the first and that of the second unit.

Total utility increases with the amount consumed but at a diminishing rate. When the second unit of rasagolla is consumed the increase in total utility is 180, when the third unit is consumed it becomes 230. Total utility increases, reaches at a maximum point and thereafter declines.

According to Marshall, “As the consumption (or possession) of a goods increases unit by unit, the marginal utility of the goods diminishes while its total utility increases, but at a diminishing rate”.

Importance of the Law of Diminishing Marginal Utility:

1. The law helps to solve the paradox of value. The law tells us that when the stock of the commodity with the consumer is high, the marginal utility of the commodity to the consumer is low. Price of a commodity depends on its marginal utility and not on total utility.

2. The law tells us to justify progressive taxation.

3. The law is the basis of various law of consumption. For example, the law of demand is directly based on the Law of Diminishing Marginal Utility. The concept of consumer’s surplus and the Law of Equi-marginal Utility are also based on this law.

Law of Equi-marginal Utility:

Human wants are unlimited, but his means to satisfy these wants are limited. That is why a rational human being will go on purchasing a commodity up to the point when marginal utility of the commodity becomes equal to the price paid. He will stop purchasing the article when he feels that he will get more satisfaction if he spends his money on something else. Thus the consumer substitutes a goods of greater utility for one of less utility while spending each unit of money.

In this process, he reaches a point where further substitution becomes unnecessary. This is because, at that point, money is seen to have equal marginal utility in each use. In other words, the last unit of money spent on each goods gives the same amount of utility to the consumer. The way of distributing the limited money income on several alternative goods to get maximum satisfaction is the Law of Equi-marginal Utility.

The Law of Equi-marginal Utility states that the marginal utilities of different commodities to a person at any particular time are proportional to the prices paid for them. The essence of this law is that it explains the manner in which the consumer should allocate his income among various commodities in order to get maximum satisfaction.

This law is also called the Law of Substitution. According to Marshall, the Law may be stated: “Money at the disposal of a consumer is distributed among several uses in such a way that it has the same marginal utility in all.”

This law may be illustrated by an imaginary example. Suppose a man has five rupees and he needs two goods A and B. He spends money rupee by rupee. He thinks that the first rupee spent on ‘A’ would give him 20 units of utility. Each subsequent rupee spent on ‘A’ would give him lower and lower utility in accordance with the Law of Diminishing Marginal Utility. Similarly, he would get progressively diminishing utility from every successive rupee spent on ‘B’. This can be represented in the following table.

From this table it can be seen that the consumer will spend the first rupee on ‘A’ and not on ‘B’. He would get 20 utility from A and 19 utility from B. On this basis he would spend the second rupee on B, the third rupee on A, the fourth rupee on B and the fifth rupee on A. Thus he spends three rupees on A and two rupees on B.

It may be seen that the utility from the third rupee spent on ‘A’ is 16 and that from the second rupees spent on B is also 16. Thus the marginal utility of money on both the commodities has become the same. It will be seen that this way of distributing five rupees gives him maximum satisfaction. In this distribution the total utility is (20 + 18 + 16 + 19 + 16 = 89). If he will spend all his five rupees on ‘A’ his total utility will be (20 + 18 + 16 + 14 + 12 = 80). This is less than the first one. If he will spend two rupees on ‘A’ and three rupees on ‘B’, then his total utility will be (20 + 18 t 19 + 16 + 13 = 86) and this distribution also gives him less satisfaction.

The law is called the Law of Equi-marginal Utility, because satisfaction is maximized by making the marginal utility of money equal in all uses to which the limited money income is put. Only if the prices of goods are the same, the equality of marginal utility of money in all uses would mean equality of marginal utilities of commodities. The law requires that the marginal utility of money in each use will be satisfied.

This law is also called the Law of Substitution, because goods of utility substitute goods of less utility. This can be represented in a diagram.

Along OX axis, we measure successive rupees spent separately on A and B and along OY axis we measure the utility of each rupee spent on A and B. The diagram shows that the first rupee spent on A gives AA’ utility, the second rupee BB’, the third CC and so on. The first rupee spent on ‘B’ yields MM’ utility, the second NN’ utility and so on.

It is seen that CC = NN’. Thus the consumer equalizes marginal utility of money on both the commodities A and B by spending three rupees on A and two rupees on B from Rs. 5/- which are at his disposal. Any other allocation of consumer’s income of Rs. 5/- would not maximize satisfaction.

Limitations of the Law:

1. The Law of Equi-marginal utility has a great practical significance and it is applied to all branches of economic activity.

2. It is useful to individual as one can get maximum satisfaction by allocating his finds among various commodities.

3. This Law is equally important to the producer. The main aim of the producer is to get maximum profit. He can maximize his profit only by minimizing the cost of production.

4. This law has great importance to the Government to do maximum welfare of the society through minimum expenditure. The law is useful in guiding public expenditure among different lines of activity.

5. The law is applicable in the field of using scarce resources in different lines in the distribution of assets in various forms and between spending and saving.

Thus, the Law of Substitution is of great practical importance in different fields of economic activity.